Monday, October 15, 2012

I'm a big fan of market cycles. What I mean by this is that certain markets will do well during certain economic times. Put another way, the overall trend in certain markets can tell us a great deal about the underlying economic condition in the economy.

For example, commodity prices typically start rising at some point during the weakest point of a recession. At this time, higher risk traders start to take small positions in goods such as oil and copper in anticipation of increased demand as the economy comes out of recession. Prices continue to generally rise until a point when orders for these goods start to fall or stockpiles start to increase at a rate higher than industrial inputs (this is a situation that is currently happening in China). At this time, traders start to sell their positions or increase their shorts (or some combination thereof). The same cycle is true for stocks, except traders are expecting an increase in profits as the economy expands.

I mention this now in respect of the bond markets. The spread between the 10 year treasury and 3 month treasury bill is usually a good indicator of where the economy is in regards to its larger expansion/contraction cycle. Consider this chart:

The chart above shows the spread between the 10 year CMT and 3-month treasury bill. Notice that this yield compresses as the economy expands, leading to an inverted or very flat yield curve between 12-18 months before a recession begins. Let's consider why this happens.

The primary reason why yield curves invert is that as the economy continues to expand the Fed typically starts to raise short-term rates to slow inflation. Obviously, this lowers the spread between the 10 and 3-month bond.

In addition, at some point late in the expansion it becomes obvious that the Fed will start to lower interest rates to goose a slowing economy making all longer bonds currently on the market that much more valuable. For example, suppose the 10 year bond has a face value of 5% when it becomes more and more obvious that the Fed will have to lower rates within the next 12-18 months. That means the 10 year bond will become the highest yielding bond on the market, making it the most valuable. In addition, this occurs at a time with the economy is slowing, lowering inflationary pressures, making bonds that much more attractive.

Finally, as the economy slows, interest bearing securities become more attractive because the value of other asset classes (equities and commodities) is more based on economic growth, whereas bonds at least have a fixed coupon amount.

In the above scenarios, short term rates are rising and long term rates are dropping, leading to a compressed yield curve.

I mention all this because right now the Fed is deeply involved with the bond markets -- a move which I support 100%. The Fed is the only entity who has the ability to act right now, especially with Congress paralyzed between two camps of competing children. Given the unemployment rate, someone has to act if only for reasons of basic decency. However, the question on my mind is the following:

Is the Fed's intervention so extreme as to distort the yield curve in such a high degree that the action is rippling through the markets and distorting all of them in a more than trivial manner?

Consider these charts:

The above four charts show the short (1-3 years), intermediate (5-7 years), belly (7-10 years) and long-end (20+ years) of the treasury market. All have been rallying over the last few years, partially as a result of Fed intervention. However, here is my big question regarding these charts:

Is money flowing into the treasury market in a large enough degree that the values of the other markets are artificial? For example, should there be more money flowing into the commodity markets in anticipation of rising values?

Right now, I have no answer to the above question. It could simply be a theoretical exercise. However, it's something that's been on my mind for some time.